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Ina Drew, JPMorgan's former chief investment officer, couldn't parse the London whale's jargon.
Masked by Gibberish, the Risks Run Amok
By FLOYD NORRIS
Can anyone manage a big bank these days? Should anyone try?
Or should we simply conclude that playing in the modern world of derivatives is best left to those whose survival is not critical to the nation’s economy, and who do not benefit from government-backed deposit insurance?
That question is brought to mind by a reading of the fascinating — well, to me, anyway — story of how JPMorgan Chase got into the mess of the London whale trades that dominated the financial news last year, as told in a report by the Senate Permanent Subcommittee on Investigations that was released last week.
Much of the attention has focused on what Jamie Dimon, the chief executive, knew and when he knew it, and the extent to which the bank intentionally deceived regulators and investors as the investment strategy was blowing up.
I, on the other hand, was struck by the sheer incompetence and stupidity documented in the report.
Consider the following presentation written by Bruno Iksil, the whale himself, on Jan. 26, 2012, as the losses were growing. He called for executing “the trades that make sense.”
He proposed to “sell the forward spread and buy protection on the tightening move,” “use indices and add to existing position,” “go long risk on some belly tranches especially where defaults may realize” and “buy protection on HY and Xover in rallies and turn the position over to monetize volatility.”
That presentation was made to a JPMorgan group called the International Senior Management Group of the Chief Investment Office, which seems to have approved it.
If the proposal does not make sense to you, don’t despair. It is largely gibberish.
“This proposal,” the Senate report states, “encompassed multiple, complex credit trading strategies, using jargon that even the relevant actors and regulators could not understand.” The subcommittee asked officials of both JPMorgan’s Chief Investment Office, or C.I.O., and its regulator, the Office of the Comptroller of the Currency, just what that meant. Nobody seemed to know. (Mr. Iksil, safely overseas, chose not to talk to the subcommittee staff.)
Ina Drew, the bank’s chief investment officer at the time, who supervised the group, said she did not know. One risk officer at the bank said he thought Mr. Iksil was simply proposing a strategy of buying low and selling high. Of course, that is a fine strategy if markets cooperate. But anyone who simply proposed that would have been seen to be blowing smoke. Use all that jargon, and some people will assume you are actually saying something.
The comptroller’s office was able to explain some of what was said, but no one seemed to be sure just what a “belly tranch” might be. The subcommittee speculated it might refer to a security with more credit risk than the safest ones, but less risk than the riskiest ones.
In any case, after the meeting Mr. Iksil embarked on a disastrous strategy that led to larger and larger losses. The portfolio he was running — which the bank initially said was a hedge to reduce its exposure to a general deterioration of credit conditions — became one that would benefit from credit conditions improving.
Over the next two months, as the losses grew, neither senior bank officials nor regulators seem to have had a good understanding of what was happening.
The bank officials were preoccupied with making the mess seem less messy. That involved what they called defensive trading — buying what they already owned to keep market values from falling further — and, when that did not work, fudging the valuations. It involved changing risk models to make what was going on seem to be less risky than it was, and coming up with creative ways to calculate how much capital was really needed.
The regulators seem to have been in their own “see no evil, hear no evil” world. When they eventually had to pay attention, the comptroller’s officials were not bothered by the bank’s withholding of information from them. Instead, one top official dismissed the entire problem as little more than “an embarrassing incident.” Comptroller’s officials immediately said the trades were perfectly proper hedges, something that turned out to be untrue.
“The ability of C.I.O. personnel to hide hundreds of millions of dollars of additional losses over the span of three months, and yet survive internal valuation reviews, shows how imprecise, undisciplined and open to manipulation the current process is for valuing credit derivatives,” the subcommittee reports states. “This weak valuation process is all the more troubling given the high-risk nature of synthetic credit derivatives, the lack of any underlying tangible assets to stem losses, and the speed with which substantial losses can accumulate and threaten a bank’s profitability.”
Eventually, Ms. Drew became furious and ordered the trading halted in late March. That came after she concluded she had been deceived about how much trading was going on and became upset by wildly varying estimates of just how much “risk-weighted capital” was needed to back the trading positions. It was, she explained to the subcommittee staff, making her appear “incompetent.”
Risk-weighted capital, by the way, is a tale unto itself. Banks calculate how much capital they need based not on total assets, but on how risky the assets are. Gaming those calculations seems to have been a preoccupation at the bank.
One way to respond to this is to say the regulators need to do a better job, and to be less willing to believe what they are told. The so-called Volcker Rule, which is supposed to stop banks from engaging in proprietary trading but allow them to hedge or engage in market-making activities, should be completed and strictly enforced.
It is hard to disagree with that prescription, but perhaps even harder to believe that it can be effectively administered.
What evidence is there that playing in these opaque and complicated derivatives markets has helped banks do the job that justifies giving them the benefit of deposit insurance? That job involves the allocation of capital, the maintenance of payment systems and the protection of depositors. Why let banks play in these markets at all?
If we are going to allow that, then there is a case for smaller banks. If one of them turns out to be as incompetent and dishonest as this one was, at least the bank would not be critical to the system, and the losses presumably would be much less than the $6.2 billion JPMorgan eventually owned up to.
I called Anat Admati, a Stanford professor and co-author of an insightful new book, “The Bankers’ New Clothes,” which advocates forcing banks to be far better capitalized than they are now, with less debt and more equity, as they were before deposit insurance was created. I asked what she thought of the Senate report. “We discover these risks when it is too late,” she said. “Next time it could be $10 billion.”
Back in 2008, when the financial system was starting to teeter, regulators assured us the banks were well capitalized. They were wrong then, and this report does not reassure us that the regulators have a much better handle on the situation now.
“My first stress test,” Ms. Admati told me, “is the test of prosecution.” She noted a recent comment by Eric H. Holder Jr., the attorney general, that some banks were so large that he feared it would “have a negative impact on the national economy, perhaps even the world economy,” if criminal charges were filed against the bank.
“If the economy cannot stand them being prosecuted,” she said, “they fail the stress test.”
Nearly two decades ago, one of the great names in international banking, Barings, disappeared. It was destroyed by a fraud committed by Nick Leeson, a trader based in Singapore, who became a star by reporting huge profits from a trading strategy involving derivatives that, by today’s standards, were remarkably simple.
In reality, there were no profits, just big losses that he managed to conceal until the firm collapsed.
When auditors and bosses asked how he was making all that money, Mr. Leeson later explained, he responded with meaningless but impressive-sounding jargon.
“Luckily for my fraud, there were too many chiefs who would chat about it at arm’s length but never go further,” Mr. Leeson wrote in his memoir. “And they never dared ask me any basic questions, since they were afraid of looking stupid about not understanding futures and options.”
Not much has changed.
Floyd Norris comments on finance and the economy at nytimes.com/economix.
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